Independent Logic - Macro Horizons

Ian Lyngen:

This is Macro Horizons episode 280: Independent Logic, presented by BMO Capital Markets. I'm your host, Ian Lyngen, here with Ben Jeffery and Vail Hartman to bring your thoughts from the trading desk for the upcoming week of July 1st. Independence Day is this week. We'd make a joke about the movie, but we fear getting slapped.

Each week we offer an updated view on the US rates market and a bad joke or two. But more importantly, the show is centered on responding directly to questions submitted by listeners and clients. We also end each show with our musings on the week ahead. Please feel free to reach out on Bloomberg or email me at ian.lyngen@bmo.com with questions for future episodes. We value your input and hope to keep the show as interactive as possible. So that being said, let's get started.

In the week just passed, the biggest event came in the form of the core-PCE figures for the month of May. Now, the market already had the combination of CPI and PPI, and so the as expected 0.1% print was in line with what investors were largely anticipating. On an unrounded basis, this came in at 0.083%, which made it the lowest core inflation read on the Fed's preferred measure since November 2020.

This data was consistent with our expectations for September to be the most likely departure point for the Fed's upcoming rate normalization cycle, although we're certainly cognizant that there are still three more CPI prints between now and the September 18th meeting. The price action in the week just passed also to a large extent conformed with expectations.

10-year yields have been consolidating within a definable range, that range being the recent low yield print of 4.186% and the 200-day moving average, which comes in at roughly 4.35%. The process of consolidation in the bottom of the recent range, which is precisely what we are seeing, is constructive for the next leg of any potential move.

We're anticipating that Treasuries will rally further and are watching that 4.186% level as a proverbial line in the sand in the event of either a more benign take on the employment landscape via the upcoming payrolls release or during the following week, confirmation that the cooling trend in inflation has extended to June, representing a solid quarter in the Fed's attempt to reestablish price stability.

The shape of the yield curve remains very topical and also well contained within the prevailing range. The range trading thesis is unlikely to survive the entire summer, although for the next couple weeks we expect that consolidation will trump any potential trending of the market. There's little question that in US rates we're very much in the mode of reprice, consolidate, repeat, and the major repricings continue to be triggered by the US fundamentals of employment and inflation.

One caveat worth adding is that as the Fed remains on hold, even if September is expected to see the first rate cut, there's a wider and wider divergence in between the Fed and other major central banks. In this context, the ECB is the obvious touchstone suggesting that this divergence cannot continue indefinitely.

Historically, there are certainly plenty of precedence for the Fed to be going a different direction or late or early in joining the rest of the major central banks, but such policy differences tend not to be long-lived. European politics continue to be influential and the results of the first round of the French elections will undoubtedly contribute to the tone early next week as the market returns for a holiday shortened trading week.

Vail Hartman:

The list of evidence supporting a September rate cut from the Fed continues to build as the market's been ascribing better than even odds to a late Q3 rate reduction. The Fed's preferred measure of inflation in core-PCE during the month of May showed the lowest monthly gain since November 2020, with the unrounded figure coming in at 0.083%. The move brought the three month annualized rate down to 2.7% and back within one percentage point of the Fed's 2% inflation target from 3.5% in April and 4.5% in March.

While Q2's inflation data has surely been welcome from the Fed's perspective, it doesn't change the fact that the Fed still needs more convincing on the inflation front. And with three CPI releases remaining ahead of the September FOMC meeting, the market will be looking for further evidence of cooling inflation that builds upon the committee's confidence that inflation is on a sustainable path to 2%.

Ian Lyngen:

And when we put this in the context of the upcoming payrolls report, not only will the market be watching the headline figures and the unemployment rate, but also average hourly earnings will be essential in the Fed's understanding of whether or not the US economy has moved past the point of risking a wage inflation spiral. Recall that the supercore measure of CPI was flat in the month of May.

And this certainly will offer some solace for monetary policymakers as we contemplate the next three months’ worth of data and how that will ultimately flow through to the Fed's decision of whether or not to cut in September or roll forward rate cut expectations to the December meeting. Perhaps the most relevant debate at the moment isn't necessarily when the Fed begins cutting rates, but when it ends.

Is the market going to be faced with a series of fine-tuning rate cuts call it 75 or 100 basis points worth of rate reduction over the course of the next 12 months and then a pause, or will the first rate cut represent the beginning of quarterly cuts until we get back to neutral? From the market's perspective, the latter seems to be the more likely outcome. However, we're all too cognizant that it's ultimately incumbent upon the data to dictate whether policy rates make it back to neutral or if some degree of a restrictive policy stance will be warranted for the next couple years.

Ben Jeffery:

And to bring up a classic monetary policy cliche as it relates to the question of how far the Fed is going to cut before arriving at terminal and then what arrives on the other side of that terminal, driving the policy car while looking in the rear-view mirror was applicable during the hiking cycle as the lagged impact of monetary policy tightening took a while to flow through to the economy and I would argue has only just recently started to materialize within the inflation and probably more importantly, employment data. That same logic holds in the easing direction.

So that means that even after the Fed begins cutting, whether that's in September, November or December, the true benefit especially for the labor market is probably not going to really show up until several months or even several quarters later. In a conversation with an especially astute client we had earlier this week, the observation was made that in a similar way that the Fed was too slow to react to the increase in inflation we saw after transitory was abandoned, the Fed is now being too slow to respond to the start of an economic inflection in the other direction.

We now have another month's worth of convincing evidence that inflation is cooling. We have last month's labor market data that shows a fine, but undoubtedly softening picture. Consumption via personal spending, retail sales, some of the consumer confidence metrics are all pointing to an outlook on the household level that's starting to come under pressure. And yet for the time being, the Fed is firmly sticking to the higher for longer mantra. And as we heard from Bostic this week, one rate cut this year is his baseline assumption, but there could be none.

And generally speaking, after we got the latest SEP, it's still clear that the Fed's bias is to err on the side of being more hawkish and fewer rate cuts sooner, even as some of the data is starting to increasingly justify a less restrictive policy stance. So maybe they are being too late to respond.

Ian Lyngen:

Well, one thing is certain that there is something going on in the real economy from a slowing perspective. Now, one of the more relevant debates is whether or not this is economic slowing that the Fed is happy to see or if it's ultimately going to run a bit further than the Fed would like to see.

And to your point, Ben, I think that the lagged impact of monetary policy is key in determining whether or not the Fed has overstayed its welcome at terminal. To the Fed's defense, however, reestablishing the assumption of price stability is more important than avoiding a recession. And the data during the second quarter at least suggests that consumer price inflation is conforming with what the Fed would like to see.

Ben Jeffery:

And it's exactly that that helps explain why it is the market has basically reset to its lowest yield levels since March. Obviously, some of the inflation data in the earlier part of this year was enough to inspire what will characterize as one last round of material bearishness this cycle that got 10-year yields beyond 4.70%. And since then, with each passing month and each additional data point that is conforming to what the Fed wants to see, that in turn has kept demand for Treasuries waiting at higher yields firmly intact and limited the scale of any subsequent selloff we've seen.

So especially as June comes to an end and July trading conditions set in with what that means for conviction and the sustainability of the price action, the fact that the lower bound of the trading range for 10 year yields is below 4.20% and not above 4.75% speaks to this idea that we've made it beyond the economy and inflation reaccelerating and now it's the down slope of the economic cycle that's going to dictate the price action in the medium and longer term.

I would also add what we've seen in the primary market as another piece of evidence that reinforces this idea as last year's generally weak auctions have been replaced by fairly solid sponsorship, with all three of this week's result the latest example of that.

Vail Hartman:

End-user demand in the primary market for Treasuries has almost universally picked up this month owing in large part to elevated indirect bidding. And it's been since the first auction of the month in the June 10th three-year sale that we've seen a coupon auction tail. In the last trading week of June, we saw the two-year auction stop on the screws with a solid non-dealer bid, fives stop through by 0.6 basis points, and the 7-years stop through by 0.3 basis points with the highest non-dealer allocation since October 2023. The recent performance of coupon auctions is consistent with a market that appears to have made a durable shift into dip buying mode even as rates have repriced to a lower plateau.

Ian Lyngen:

It's with this backdrop that I think it will be fascinating to see how the market absorbs the payrolls report. Now, Thursday's market closure and Wednesday's early close will more likely than not provide sufficient incentive for investors to call it a five-day weekend. But the reality is the BLS is nonetheless releasing the employment situation report on Friday morning at 8:30.

Now, our expectations are for the price action associated with the release itself to be a bit choppier than usual, as comparatively light staffing levels will leave the market reluctant to fade the initial response. All of that being said, in the event that the data comes in close enough to expectations, attention will very quickly shift to the July 10th release of June-CPI.

At present, our expectations are for a 0.2% on the core-CPI measure, which would provide yet further evidence for the Fed that a September rate cut should be considered the path of least resistance.

Ben Jeffery:

And this past week wasn't only a story about the domestic fundamentals. Obviously Canadian and Australian CPI and those upside surprises contributed to the price action and the overall discourse earlier in the week, as did the moves in dollar-yen as the yen continues to make new lows and trigger renewed speculation about on the one hand currency intervention from the Ministry of Finance and on the other forced selling of Treasury positions from large Japanese holders of Treasuries outside of the official sector who simply can no longer afford to hold the bond positions they have that are still deeply underwater simply from a price perspective, but also given the strength of the dollar and what that means for yen adjusted returns.

While Japanese selling is going to undoubtedly remain topical over the next several weeks and probably over the course of the summer, it's important to draw the distinction between the potential for currency intervention from the Bank of Japan and Ministry of Finance, which we suspect would be generally funded by sales of very short dated Treasuries, just given the fact that selling 10 billion bills is a much easier endeavor than selling 10 billion long bonds.

On the private side of the equation, it's those holdings that can be concentrated a bit further out the curve, even as far as the 20-year sector. It's there that the duration associated with tens of billions in selling in perhaps relatively illiquid securities holds the potential to drive a more meaningful price response.

Vail Hartman:

And shifting back to the topic of domestic monetary policy briefly, I'll highlight one of Fed Governor Bowman's comments this week that we should consider a range of possible scenarios that could unfold when considering how the FOMC's monetary policy decisions may evolve. Now, considering the high level of uncertainty regarding the outlook at the moment, I think the range of scenarios offered by Fed officials in addition to their baseline outlooks should not go overlooked, especially considering the accuracy of their prior baseline assumptions.

Earlier this week, we heard Fed Governor Cook acknowledged the risk that persistently high inflation durably increases household inflation expectations, which could mean keeping rates in restrictive territory for longer. This will leave datapoints like the U. Mich Survey's inflation expectations, and the New York Fed's inflation expectations in focus, in addition to the realized inflation data. We also heard Fed Governor Cook acknowledge a scenario in which the economy or the labor market weakens more sharply than expected in her baseline, which could lead to a Fed response.

And we also heard Fed Governor Bowman go as far as admitting that she remains willing to hike the Fed funds rate at future Fed meetings if progress on inflation stalls or even reverses.

Ian Lyngen:

So the biggest takeaway from the incoming Fedspeak has been if one thing is certain, it is uncertainty.

Ben Jeffery:

Certainly.

Vail Hartman:

For sure.

Ian Lyngen:

Are you sure?

In the holiday shortened week ahead, the Treasury market will have the typical round of information that precedes the release of June's payrolls report. However, it will be condensed into the first two and a half trading days of the week. We have ISM Manufacturing on Monday, which is seen coming in below the pivotal 50 level. And far more importantly, in terms of trading for Treasuries, we'll see the May JOLTS data.

Now, the JOLTS data is a month behind, but it has nonetheless proven to be a very tradable event and continues to show job openings moderating back to, but not yet reaching pre-pandemic levels. Within the JOLTS report, we'll be watching the quits rate, which has returned to pre-pandemic levels. All of this suggests that there are growing signs that while monetary policy does function with a lag, it is finally starting to catch up with the real economy.

And the biggest question that this raises isn't whether or not we're going to see balance return to the labor market, but rather if the Fed risks overshooting the mark and we find ourselves in an environment with higher unemployment, slower job gains, and flagging consumption over the summer months. Recall that historically, anytime the unemployment rate is more than half a percent off of the cycle low, it tends to spike.

And it doesn't spike by 50 or 75 basis points. It spikes by 200 or 300 basis points. For context, as of May, the unemployment rate was six-tenths of a percent off the cycle low giving rise to our concern that the labor market is reaching an inflection point. It's with this backdrop that we'll observe that during nonfarm payroll survey week, initial jobless claims were their highest for a comparable week since June of 2023.

Recall that in June of 2023, not only did nonfarm payrolls disappoint versus the consensus coming in at 209k, but the following two payrolls reports came in below 200,000. Now, in the event that we see a comparable pattern playing out this summer, that would clear the path for a September rate cut, assuming, of course, that we don't see a reflationary surge define the next three months.

The week ahead also contains the Minutes from the most recent FOMC meeting. Although given that we have the updated SEP and the Minutes are released precisely at the recommended early close, we don't expect that it will be a particularly tradable event. Nonetheless, we will be looking for details about the discussion around the timing of the first rate cut, and of course, any context for the degree to which the Fed is willing to let QT continue in the background once it begins cutting rates.

All else being equal, we don't expect the QT will survive the first two rate cuts, and we anticipate by the end of this year the balance sheet will be back in simply maintenance mode. We've reached the point in this week's episode where we'd like to offer our sincere thanks and condolences to anyone who has managed to make it this far. And as the July 4th holiday approaches, we look forward to a few old traditions of barbecue and fireworks and a new tradition of preparing for the payrolls report.

Thanks, BLS.

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy effort as interactive as possible, we'd love to hear what you thought of today's episode. So please email me directly with any feedback at ian.lyngen@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's Marketing Team. This show has been produced and edited by Puddle Creative.

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